Defense-sector stocks fuel your portfolio’s tank

Priorities shift, but top military contractors poised to win battle of the budget

By

ChristopherHinton

NEW YORK (MarketWatch) — The Pentagon is under siege by deficit hawks eager to slash what they consider a bloated defense budget, but many firms in the aerospace and defense industry appear able to outflank the opposition.

Not every military program is under Uncle Sam’s scalpel, of course. While the overall defense budget is due to decline, investment spending is likely to rise modestly, though priorities will change. Companies involved with equipment and technology better-suited for fighting small wars, insurgencies and defending against cyberterrorism can expect strong demand.

Boeing wins $30B defense contract

(1:15)

The Pentagon awarded Boeing Co. an aerial refueling tanker contract worth more than $30 billion. But WSJ's Nathan Hodge says the deal could unleash a wave of political controversy.

“There’s going to be continued pressure on the budget, and that will be challenging,” said John Sheehy, manager of the specialized Fidelity Select Defense & Aerospace Fund. “But there are better funded parts [of the sector], such as surveillance and reconnaissance, cyber-security and helicopters.”

The biggest U.S. military contractors have been repositioning, acquiring smaller companies in high-growth areas to offset businesses that are cooling. That will help shareholders seeking steady profits, while giving traders the opportunity to bet on the next premium-paying merger, investors and analysts say.

The defense industry’s response to changing conditions had buoyed investors over the past few months. The Spade Defense Index
DXS, +0.12%
a capitalization-weighted index that tracks publicly traded defense stocks, hit its highest point since June 2008 in early February, as the austerity cloud hanging over the U.S. budget abated to reveal firmer-than-expected spending commitments. Read more: Boeing wins huge Pentagon contract to build aerial refueling tanker.

But unrest in the Middle East and North Africa, particularly the recent violence in Libya, has prompted some investors to take profits in defense stocks. The upheaval raises concerns about delays with arms shipments to a region that accounted for about 45% of total U.S. weapons exports in 2010.

“The selloff in the aerospace sector could prove to be a good buying opportunity,” Stallard said.

Developing a strategy

In April, 2009, U.S. Defense Secretary Robert Gates started cancelling or reducing weapons programs. The Great Recession had hit the federal budget, and the defense-budget growth rate appeared vulnerable. By curtailing spending, Gates hoped to ward off deeper cuts by Congress.

The wind down in spending was never as draconian as Wall Street had feared, but it served as a good example of how investors should be careful with companies that rely on a single large customer — in this case, the U.S. government.

“Diversification is the cardinal rule of investing,” said Charlie Smith, the chief investment officer at Fort Pitt Capital Group, a financial management firm. “Get into [defense] companies with commercial sides.”

For investors seeking defense-industry diversification across many business lines, Fidelity Select Defense & Aerospace
FSDAX, -1.16%
counts United Technologies, Boeing and Precision Castparts Corp.
PCP, +0.00%
which makes fasteners used in building aircraft, among its recent top holdings.

Headwinds and tailwinds

Meanwhile, the reduced U.S. military presence in Iraq and the scheduled drawdown of troops from Afghanistan beginning this summer, will mean less demand for battlefield-related equipment, analysts noted.

“I’d avoid companies that supply the military’s high-volume consumerables, like Alliant, or any other company that makes the stuff soldiers carry on their backs,” Smith said.

But the so-called primes shouldn’t be completely written off, said Jeff Middleswart, manager of the Vice Fund
VICEX, -1.52%
which specializes in stocks for the gaming, tobacco and alcohol industries, as well as aerospace and defense.

“The big guys get tons of cash flow,” Middleswart said. “They’re buying back stock and they can increase their dividends. Right now the market as a whole is paying out a 1.8% dividend yield, while the defense sector is more than a 3% yield. And the stocks are trading at only 10-times earnings.”

Historically, defense shares trade at 15-times earnings. Price-earnings ratios could mean a stock is undervalued, but it also means investors expect profits to decline.

Among Middleswart’s favorites: Raytheon Co.
RTN, -0.42%
L-3 Communications Corp.
LLL, +0.23%
and General Dynamics Corp.
GD, +0.61%
which also owns Gulfstream business jets, which appears to be on the cusp of a rebound after four years of withering sales.

Yet investors should be wary of pension problems that could hinder a company’s intent to raise dividends or repurchase stock. For example, shares of Lockheed Martin Corp.
LMT, -0.02%
may be cheap right now, but the company also has the most growth risk because of costly pension obligations, analysts note. Last year, Lockheed contributed more than $2 billion to its retirees’ pension plan.

“Pension contributions, both required and discretionary, could be the largest area of cash deployment in 2011,” said Craig Fraser, an analyst with bond-rating firm Fitch Ratings. “The defense sector has some of the largest corporate pension plans in the U.S., some of which are significantly underfunded.”

Pension obligations aside, the top 15 U.S. aerospace and defense companies were sitting on some $56 billion in liquidity at the end of the third quarter, according to Fitch Ratings.

Some of that cash will be used to buy smaller companies. Firms considered possible acquisition targets include Science Applications International Corp.
SAI, +0.00%
AeroVironment Inc.
AVAV, -0.76%
and Sparton Corp.
SPA, +1.26%
according to analysts and shareholders.

Science Applications, or SAIC, builds products for homeland and border security, and has substantial international exposure, making it attractive to a company looking for a business in that field, such as Raytheon or L-3, analysts say.

AeroVironment, meanwhile, manufactures unmanned aircraft and Sparton builds monitoring and scanning equipment used in perimeter security, which could appeal to General Dynamics or Northrop Grumman Corp.
NOC, +0.20%

In addition to snapping up some smaller, faster-growth companies, Northrop plans to spin out its shipbuilding business to boost the value of its other assets.

Once the transaction is complete, Northrop shares may see the biggest gains from the Pentagon budget adjustment, as the company seems to be involved with programs in line to receive increased funding, said Michael Lewis, an equity analyst with Lazard Capital Markets.

Northrop has businesses in unmanned aircraft, satellite communications, cyber security and data analysis, all of which are pegged to see more funding relative to other parts of the U.S. budget.

“Companies are still announcing new contracts,” said Middleswart, the Vice Fund manager, about the defense industry. “And they are buying up companies that will allow them to slash costs through scale and efficiency, and that will help with profits.

Intraday Data provided by SIX Financial Information and subject to terms of use.
Historical and current end-of-day data provided by SIX Financial Information. Intraday data
delayed per exchange requirements. S&P/Dow Jones Indices (SM) from Dow Jones & Company, Inc.
All quotes are in local exchange time. Real time last sale data provided by NASDAQ. More
information on NASDAQ traded symbols and their current financial status. Intraday
data delayed 15 minutes for Nasdaq, and 20 minutes for other exchanges. S&P/Dow Jones Indices (SM)
from Dow Jones & Company, Inc. SEHK intraday data is provided by SIX Financial Information and is
at least 60-minutes delayed. All quotes are in local exchange time.